The Benefits of Residential Cost Segregation Studies

1
The Benefits of Residential Cost Segregation
Studies

• Redtec Solutions, LLC
• Bryan Campo
• Don Curran

2
Disclaimers

• To better understand and appreciate what cost
  segregation is, who can get the most benefit from
  it, and how you can use it in your business and
  personal lives to generate more income, it is
  critical to first discuss how taxes affect real
  estate investors.
• It is important to note that neither Bryan Campo
  nor Redtec Solutions, LLC are licensed CPAs.
  Although this material has been reviewed with a
  reputable CPA firm, you should still consult with
  your CPA before implementing these strategies.

3
Overview

• Tax Discussion
• 3 different income buckets
• Earned Income
• Portfolio Income
• Passive Income
• 3 IRS investor/property classifications
• Dealer/Developer
• Real Estate Investor (Active Participant)
• Real Estate Professional
• Tax Strategy Summary
• Depreciation
• Cost Segregation
• Description
• Benefits
• Example
• Summary/Conclusions
• Top 10 Real Estate Tax Loopholes
• Q A

4
Tax Discussion 3 Income Buckets

• Since the 1986 Tax Reform Act, the IRS has
  defined three different buckets of income, each
  with different tax consequences
• 1) Earned Income
• 2) Portfolio Income
• 3) Passive Income
• Each of these will be explained over the next
  several slides.

5
Earned Income

• Earned income is all money you actively work for.
  
• It includes
• Wages from your job (even if the employer is your
  own company).
• Net income from your sole proprietorship.
• Income from active involvement in all
  partnerships and S Corporations.

6
Earned Income Tax Consequences

• Earned Income is the highest taxed income there
  is.
• It is taxed at your Federal Marginal Tax Rate
  (see 2008 table below)
• In addition, payroll/self-employment taxes are
  collected, bringing the highest tax rate to more
  than 40!!! (Note S Corporation distributions
  are an exception)

(Source http//www.edwardjones.com/cgi/getHTML.cg
i?page/USA/resources/tax/brackets/2008.html)
7
Portfolio Income

• Portfolio income is the money your money makes
  for you.
• It includes
• Interest (from bank/money market accounts, etc.)
• Dividends
• Capital Gains (from stock, options, currency
  sales, real estate sales, etc.)

8
Portfolio Income Tax Consequences

• For purposes of the discussion below
• Short-term Capital Gains are defined as the
  gains that are made on assets that are held for
  less than 1 year (e.g. day traders in the stock
  market, etc.)
• Long-term Capital Gains are defined as the
  gains that are made on assets that are held for
  longer than 1 year (e.g. long term stock
  positions, etc.)
• Interest and Short-term Capital Gains are taxed
  at the earned income tax rate, without
  payroll/self-employment taxes (please refer to
  slide 6).
• Qualified Dividends and Long-term Capital Gains
  are taxed as follows
• 0 for those in the 10 and 15 Federal Marginal
  Tax Brackets.
• 15 for those in the 25, 28, 33, and 35
  Federal Marginal Tax Brackets.
• One can write off up to 3,000/year in net
  portfolio losses against earned income, with any
  additional losses suspended to the subsequent tax
  years.
• Portfolio Income is taxed more favorably than
  earned income!

9
Passive Income

• Passive income is the income your investments
  make for you.
• It includes
• Income-producing real estate investments
• Business income (not-actively participating)

10
Passive Income Tax Consequences

• Passive income is taxed similar to portfolio
  income.
• However, there are incredible real estate tax
  loopholes available to offset/eliminate passive
  income to reduce your taxes to as low as 0!!!
• Some of these loopholes include
• Depreciation
• Cost Segregation Studies (talked about later in
  this presentation)
• Real Estate Professional Status
• Installment Sales
• 1031 Exchanges (traditional and reverse)
• The best part Depending on your income, level of
  participation, and investment portfolio, you can
  make money in your real estate portfolio in real
  life, show a paper loss to the IRS, and use
  this loss to write off some, if not all, of your
  earned income!!!!!
• See IRS investor/property classifications later
  in presentation.
• Passive income contains the most favorable tax
  loopholes!!!

11
Income Bucket Summary

• Earned Income You work for the money.
• Taxed as high as 40!
• Portfolio Income Your money works for you.
• Qualified Dividends and Long-term capital gains
  currently taxed up to 15.
• Interest and Short-term capital gains currently
  taxed up to 35.
• Passive Income Your investments work for you.
• With proper tax planning, may be taxed as low as
  0 (with no payroll/self-employment taxes)!
• The amount of tax benefit one gets in this
  category depends on how the IRS classifies the
  individual/property.

12
IRS Investor/Property Classifications

• According to the IRS, there are 3 different real
  estate investor/property classifications
• 1) Real Estate Dealer/Developer
• 2) Real Estate Investor (Active Participant)
• 3) Real Estate Professional
• Each classification has different tax
  consequences.

13
Real Estate Dealer/Developer

• Dealer Property held primarily for sale (e.g.
  Wholesaling, Assignments, etc.)
• Developer Subdivide or develop property (e.g.
  Rehabbing, Subdivisions, etc.)
• Tax Consequences
• Subject to ordinary income tax (i.e. marginal tax
  bracket) and self-employment tax (if not
  structured correctly).
• Cannot depreciate or cost segregate to increase
  passive loss in operating years.
• Cannot delay capital gains through installment
  sales or 1031 exchanges.

14
Real Estate Investor (Active Participant)

• Applies to properties held primarily for
  investment (i.e. long term appreciation).
• Must be able to prove active participation to
  qualify for passive loss rule (i.e. decision
  making, etc. not as stringent as material
  participation as there is no time requirement),
  otherwise one cannot write off passive losses
  against earned income.
• Passive Loss Rule Can write off up to 25,000
  in passive loss against earned income, provided
  your AGI is less than 100,000/yr.
• Phases out 0.50 for every 1 earned above
  100,000.
• Tax Consequences
• Can depreciate and cost segregate to increase
  passive loss in operating years.
• Can use installment sales and 1031 exchanges to
  defer tax liability.

15
Real Estate Professional

• Must be able to prove material participation
• 750 hrs/yr spent in real estate related
  activities (development, redevelopment,
  construction, reconstruction, acquisition,
  conversion, renting/leasing, operating, managing,
  or brokering).
• More time spent in real estate activities than in
  any other income source.
• Tax Consequences
• Can depreciate and cost segregate to increase
  passive loss during operating years.
• Can use installment sales and 1031 exchanges to
  defer tax liability.
• Can write off unlimited real estate passive
  losses against earned income!

16
Tax Strategy Summary

• Over time, it should be in your best interest to
  convert as much of your earned income as
  possible into portfolio and passive income.
• It is critical to work with a knowledgeable
  CPA/legal team in structuring your investment
  activities to minimize taxes
• Setting up the correct business entity structure.
• Utilizing cost segregation studies to maximize
  passive losses.
• Qualifying as a real estate professional, so
  that your real estate passive losses can offset
  earned income without restriction.
• For more information, please contact one of
  several CPAs that we can refer you to.

17
How Does Depreciation Work?

• Most people have heard of the depreciation
  benefit as it relates to real estate investing
• The IRS allows investors to depreciate the
  improved portion of their long-term
  income-producing residential properties over 27.5
  years (straight-line mid-month convention),
  which effectively helps the investor to show
  additional paper losses in the operating years
  the depreciation is taken.
• Depreciation is recaptured up to 25 upon sale
  (but can be deferred with a 1031 exchange or
  installment sale).
• See next 2 slides for more information on
  depreciation.
• Depreciation benefits
• Time Value of Money Free loan from IRS!
• Tax Shifting Strategy May forego taxes at a
  higher tax bracket today (i.e. 28, 33, or 35)
  to pay taxes at a lower tax bracket (i.e. 25)
  later.

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Depreciation Example
160,000
27.5 year improved bucket

• Notes
• 160,000/27.5 5,818/yr write-off!
• (assumes a full year of ownership)
• Depreciation recapture does not occur until
  the
• property is sold (see next slide).
• Can use 1031 exchanges and installment
• sales to control when you pay tax and how
• much tax you pay!
• Can elect to take the standard depreciation
  deduction
• (above) or itemize your depreciation
  deductions by
• having a cost segregation study performed on
  your rental
• property.

80
Basis 200,000
20

• Income
• - Expenses
• -------------------------------------
• Pre-tax Cash Flow (real world)
• - Depreciation, or
• - Cost Segregation
• --------------------------------------
• Adj. Pre-tax Cash Flow (paper)

40,000
Land bucket
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Graphical Depiction of Depreciation

Sale Price (after all closing costs)
300,000
Long Term Capital Gains (Taxed up to 15)
Basis upon Purchase
200,000
Depreciation Recapture (Taxed up to 25)
Time
gt 1 yr
20
What is Cost Segregation?

• Cost Segregation is a method of itemizing your
  standard depreciation deduction.
• A Cost Segregation Study effectively partitions
  the depreciable portion of the property into
• 5 year personal property (i.e. carpet, blinds,
  countertops, cabinets, ceiling fans, etc.)
• 15 year land improvements (i.e. lawn, concrete,
  landscaping, fencing, pool, etc.)
• 27.5 year improved building/structure
• The 5 year personal property and 15 year land
  improvement buckets are depreciated on
  IRS-approved accelerated schedules.
• Cost Segregation Benefits (in addition to the
  previously mentioned depreciation benefits)
• Time Value of Money Can show much greater real
  estate passive losses due to the accelerated 5
  and 15 year buckets.
• Roll Forward Benefit Can realize incremental
  cost segregation benefits from prior years w/o
  having to amend a previous return.
• Tax Shifting Strategy Convert 5 year bucket
  ordinary income basis and 15 year bucket
  recapture basis (25) to long term capital
  gain basis (15) upon sale.
• The argument could be made that, at the time of
  sale, the 5 and 15 year buckets could be sold for
  book value due to the fact that they contain
  depreciating assets (e.g. carpet, cabinetry,
  blinds, appliances, etc.). The basis that
  corresponds to the actual depreciated amounts of
  these buckets is reallocated to long term capital
  gains treatment (15)
• Please consult with your CPA, or have him/her
  contact Redtec Solutions with any questions.
• Fix and Hold Strategy Get a cost segregation
  study done before rehabbing a property to unlock
  the hidden deduction. Can write-off the
  tangible value of all personal property that is
  ripped out of the property only if a cost
  segregation study is performed prior to
  demolition.

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Cost Segregation Example
Depreciation
Cost Segregation
25,000
5 yr personal property bucket
200 DD Depreciation Method
160,000
27.5 year improved bucket
20,000
15 yr land improvement bucket
Straight-line Depreciation Method
150 DD Depreciation Method
80
115,000
27.5 yr improved bucket
Straight-line Depreciation Method
Basis 200,000

• Notes
• Cost segregation will always provide a greater
  tax
• write-off than the standard depreciation
  deduction
• because you are depreciating over smaller time
  frames!
• The real question is Does the benefit of cost
  segregation
• outweigh the cost of getting a cost segregation
  study
• performed?
• Redtec Solutions offers a free initial
• consultation to determine if cost segregation
• makes sense for your personal tax situation.

20
40,000
Land bucket
22
Graphical Depiction of Cost Segregation

Sale Price (after all closing costs)
300,000
Long Term Capital Gains (Taxed up to 15)
Basis upon Purchase
200,000
Depreciation Recapture (Taxed up to 25)
Potential Cost Segregation Recapture (Some taxed
as long term capital gains, some potentially
taxed at recapture rates, and some potentially
taxed at ordinary income rates).
Time
gt 1 yr
23
Cost Segregation Real World Example

• Here is the data from an actual property in
  Bryans real estate portfolio
• Address 10808 Mint Julep Dr., Austin, TX 78748
• Basis Upon Purchase 227,397.96
• Land Value 45,479.59 (assumed to be 20 of
  basis)

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Cost Segregation Benefit - Example

• Before cost segregation
• Improved Building/Structure 181,918.37 (80
  of basis)
• Annual depreciation write-off (assuming full year
  of ownership) 6,615.21 (181,918.37/27.5)
• After cost segregation
• 5 year personal property 35,320.35
• 15 year land improvements 16,980.04
• 27.5 year improved building/structure
  129,617.98
• Depreciation write-off 12,626.45 (year 1 alone)

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Standard Depreciation vs. Cost SegregationExample

• In terms of write-offs
• Over 5 years, there are 30,000 of additional
  write-offs as a result of performing the cost
  segregation study (not including the write-off
  for the cost of the study)!
• In terms of actual federal tax savings over the 5
  years (either in the form of a tax refund, or in
  the form of less taxes owed)

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Cost Segregation Summary

• Cost Segregation can be thought of as a way to
  itemize your standard depreciation deduction
  (similar to your personal tax return) to generate
  more phantom write-offs.
• Cost Segregation is an advanced depreciation
  technique wealthy people use to leverage existing
  loopholes in the IRS tax code to maximize profit.
• Redtec Solutions, LLC typically charges 1,500 -
  3,000 per property, which includes
• A comprehensive report that contains an itemized
  list of all personal property/land improvements
  in your property, with their respective
  replacement values segregated into 5 and 15 year
  buckets (using Marshall Swifts IRS-approved
  replacement cost tables, which are updated
  quarterly).
• Representative pictures of the segregated
  personal property/land improvements.
• Contact Bryan (602-790-6408) if you have any
  questions or would like to schedule a Cost
  Segregation Study.

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Top 10 Real Estate Tax Loopholes

• 10) Controlled Group Sale Strategy For Primary
  Residences
• Lock in tax free gains while increasing your
  basis for cost segregation/depreciation!
• 9) S-Corporation Tax Treatment For
  Dealer/Developer
• Shelter much of your profit from the 15.3
  Self-Employment Tax!
• 8) Installment Sale
• Control when you pay tax by becoming the bank!
• 7) Interest/Property Tax Write-Off For
  Primary/Secondary Residences
• Up to 1M in combined write-offs!
• 6) Depreciation Write-Off
• Take advantage of the time value of money as well
  as the tax shifting strategy upon sale! (refer to
  slide 17)
• May also qualify for GO Zone bonus
  depreciation Write off 50 of improved basis
  in 1st year!
• 5) Passive Loss Limitation
• Up to 25K provided your AGI is less than 100K!
  (refer to slide 14)
• 4) 1031 Exchanges
• Control when you pay tax by rolling your profits
  and accumulated depreciation/cost segregation
  write-offs into future investments!
• 3) Tax-Free Exclusion For Primary Residence Sales
• Up to 500K (if married) or 250K (if single)
  provided you live in house 2 out of 5 years!
• 2) Cost Segregation Studies
• Take advantage of the additional depreciation
  write-offs, roll forward benefit, tax shifting
  strategy upon sale, or the hidden deduction
  benefit for fix and hold investors! (refer to
  slide 20)

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Any Questions?

• For further information on cost segregation
  studies and/or exciting investment opportunities
  available, please contact
• Redtec Solutions, LLC
• Bryan Campo
• [phone]
• Bryan_at_redtecsolutions.com
• Don Curran
• [phone]
• Don_at_redtecsolutions.com